The Fed Announces It’s Time to Panic

It isn’t often that the political right and left in this country agree on anything, but if two articles I read this morning are any indication, we may have finally found common ground on the issue of the stagnated economy. More significantly, articles in Forbes and The Huffington Post are both sounding the same alarm bells about the Fed’s actions yesterday. If there are two publications more diametrically opposed in terms of editorial slant, I can’t think of them. After all, on most issues the Huffington Post is slightly to the left of Fidel Castro and Forbes founder (and namesake) is the epitome of neo-conservatism.

What the Fed did yesterday is press the panic button. I’m sure the President and congressional Democrats can’t be too happy about that – after all, various administration members have assiduously assured us that the economy is all fine and those of us complaining are simply making mountains out of molehills. The Fed (or more accurately, the Federal Reserve Board of Governors) said, “Um, maybe not. The economy is slowing and we’re headed for a second recession.” As their statement said,

“Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months…investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls…the pace of economic recovery is likely to be more modest in the near term than had been anticipated.”

In case your wondering, when the Fed uses terms like “slower than anticipated,” that is simply a banker’s way of saying that things are really, really bad. How bad? In the January 2010 report, the “anticipated growth rate for GDP” was 2.8% – 3.2%. If you prefer, the Fed was anticipating anemic growth already – if they’re now saying the actual rate of growth is even less than that, then it’s safe to say we’re approaching negative growth. If the economy was shedding jobs during a period of supposed growth (albeit anemic growth), what happens when growth turns negative?

Thus, the Fed is panicking. That is, nine of the ten members of the Board of Governors are panicking. (I’ll get back to the tenth in a moment). It’s perfectly understandable, since the only thing that can make a banker afraid more than a lack of government bailouts is the thought of angry mobs demanding their deposits. The actions the Fed took yesterday – converting the sizable investment in mortgage bonds they currently hold into treasuries and keeping the funds rate near 0% – indicate an organization that is under the misled belief that there isn’t enough money in the economy today.

The nine members who voted for these policies ignored a huge source of money that is available, but lacks the impetus to spend. As has been widely reported, corporations are sitting on approximately $1.8 trillion in cash assets. That equals about 12% of estimated GDP for this year – or nearly double the economic “stimulus” spent by the federal government since 2008. Those huge cash reserves, if invested back in the economy, would represent the most effective stimulus possible, since those funds would be directly spent on investment, including capital expenditures and employment. But by depressing interest rates, the Fed is holding down any incentive for businesses to invest.

This point was brought up by Thomas Hoenig, the one member of the Fed Board who didn’t vote to hit the panic button. (Told you I’d get back to him). In a nutshell, Hoenig is worried that by depressing interest rates while pumping more money into the economy, all the Fed is accomplishing is creating another bubble. Nobody is prescient enough to tell you what industry that bubble will encompass (my guess is health care), but it’s certain to come. As Hoenig pointed out, in 2003 the Fed took similar actions – and gave us the housing bubble, which led to the current recession. In 1997, the Fed took similar actions – and gave us the tech bubble.

It can be argued, and perhaps rightly, that the Fed’s overzealousness in 1997 and 2003 was warranted, since monetary policy was the best option for jump-starting stagnating economies. There is a major difference this time around, and that difference is the vast cash reserves companies have built up during this recession. The Fed’s current monetary policy is a huge disincentive for those companies to invest in what are typically long-term assets with high immediate and near-term costs; namely people and equipment. How? First, by limiting inflationary pressures, there is no reason to invest cash into something that will lose value in the near-term. Once inflation does kick in (and it will; the amount of money currently floating around plus artificially depressed interest rates guarantees it), every dollar invested now loses value not only through depreciation but also in the natural devaluation that comes with inflation. (If inflation were held at the Fed’s target rate of 5%, a dollar today would only be worth 95 cents next year). It makes much more sense, from a business perspective, to invest that money into something that almost certainly will appreciate in value. It is the mindset that explains the stock market’s insane gains this year.

So what should the Fed do? I argue the Fed should look for ways to take money out of the economy – raising interest rates and selling those securities it purchased over the past 2 1/2 years. By thus shrinking the money supply, those business currently hoarding cash are forced to begin spending again. Why? Cash flow is the lifeblood of business. Right now, business can ignore normal consumer markets because they’re making huge profits by investing their capital in the stock market, in many cases buying back their own stock and driving the prices up, ensuring positive cash flow. Once the excess cash is removed from the economy, the financial markets will react as they always do to inflation: prices will drop and indices will decline, drying up the current avenue for establishing business income. Those same inflationary pressures will force businesses to reconsider investing in long-term capital – investing their cash before its purchasing power declines.

Unfortunately, the Ben Bernanke’s and other Greenspan disciples (including the Treasury secretary) are not of a mind to engage in this type of monetary policy, fearing that jump-starting the economy by raising inflation will result in the type of over-inflation from the 1970’s and wind up uncontrollable. Oddly, many left thinking economists (notably Paul Krugman) are like-minded, although they prefer government spending over monetary policy to pump more cash into the economy. Either way, I can’t help but wonder if they’re seeing the same economic landscape those of us in the real world see. Oh, and if they realize that the policies of “priming the pump” we’ve pursued for the past 2 years haven’t worked and may very well have pushed the real economy off the cliff.

My biggest fear is they don’t see it – and they’ve taken the very social order of the first world with them in their mad dash chasing after rainbows.